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AAM Viewpoints – 4 Reasons to Consider Preferred Securities if You Own Municipal Bonds


Many investors think of municipal bonds for tax-efficient income, often overlooking the potentially higher after-tax yields of preferred securities. Here are a few reasons why we believe preferreds make a compelling complement to municipal (“muni”) bonds.


  1. High coupons from high-quality issuers

    Preferred securities are issued mostly by high-quality companies in banking, insurance, real estate and utility sectors, many of them household names such as Bank of America, Prudential, AT&T and JPMorgan Chase. However, because they sit lower in the capital structure than senior and subordinated debt, they tend to pay higher income rates than similarly-rated bonds.

  2. Tax-advantaged income

    Typically, distributions from most preferreds are treated as qualified dividend income (QDI), taxed at a top rate of 20%, versus 37% for interest income (plus a 3.8% Medicare surcharge). If we conservatively assume that 65% of preferreds are QDI eligible, the effective top tax rate would be 29.8% — an 11% tax savings.


  3. Higher current income potential than munis, before and after taxes

    Using current index yields, a $1 million investment in preferred securities would potentially generate $52K per year in pre-tax income (see chart at left below). Assuming 65% QDI, that would potentially translate to $36.5K per year after taxes for investors in the top tax bracket— providing $5.7K more in after-tax income than if it were fully treated as interest. This compares favorably to municipal bonds, which potentially offer only $28K per year in tax-free income. Preferreds’ yield advantage may be narrower versus municipal bonds that are exempt from state and local income taxes for investors who purchase the bonds issued by their state or municipality of residence.

    Investors emphasizing capital preservation over appreciation may consider low-duration preferred securities, which also have the potential to offer attractive after-tax yields, as shown in the chart at right below.

    CS_111119


  4. Comparable risk

    While municipal bonds are often perceived as being lower-risk securities than preferreds, preferreds have historically compared favorably on key risk factors.

    Default rates: Long-term default rates for both preferreds and munis are comfortably below 1%, according to Moody’s data going back decades. We believe preferreds have the potential to maintain low default rates, viewing them as well positioned to withstand periods of slowing or negative economic growth. Regulators annually subject financial companies — the leading issuer of preferreds — to rigorous economic “stress tests” aimed at ensuring adequate capital reserves. The preferred market is also well represented by high-cash-flow, less cyclical companies that investors trust to make regular payments.

 


CRN: 2019-1104-7783R

The opinions and views of this commentary are that of Cohen & Steers and are not necessarily that of AAM.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.

Risks of Investing in Preferred Securities. Investing in any market exposes investors to risks. In general, the risks of investing in preferred securities are similar to those of investing in bonds, including credit risk and interest-rate risk. As nearly all preferred securities have issuer call options, call risk and reinvestment risk are also important considerations. In addition, investors face equity-like risks, such as deferral or omission of distributions, subordination to bonds and other more senior debt, and higher corporate governance risks with limited voting rights. Risks associated with preferred securities differ from risks inherent with other investments. In particular, in the event of bankruptcy, a company’s preferred securities are senior to common stock but subordinated to all other types of corporate debt. Throughout this commentary we will make comparisons of preferred securities to corporate bonds, municipal bonds and Treasury securities. It is important to note that corporate bonds sit higher in the capital structure than preferred securities and therefore, in the event of bankruptcy, will be senior to the preferred securities. Municipal bonds are issued and backed by state and local governments and their agencies, and the interest from municipal securities is often free from both state and local income taxes. Treasury securities are issued by the U.S. government and are generally considered the safest of all bonds since they are backed by the full faith and credit of the U.S. government as to timely payment of principal and interest; additionally, U.S. Treasury interest is generally free from state and local income taxes.

Preferred funds may invest in below-investment-grade securities and unrated securities judged to be below investment grade by the Advisor. Below investment-grade securities or equivalent unrated securities generally involve greater volatility of price and risk of loss of income and principal and may be more susceptible to real or perceived adverse economic and competitive industry conditions than higher-grade securities.

Duration Risk. Duration is a mathematical calculation of the average life of a fixed-income or preferred security that serves as a measure of the security’s price risk to changes in interest rates (or yields). Securities with longer durations tend to be more sensitive to interest rate (or yield) changes than securities with shorter durations. Duration differs from maturity in that it considers potential changes to interest rates, and a security’s coupon payments, yield, price and par value and call features, in addition to the amount of time until the security matures. Various techniques may be used to shorten or lengthen the Fund’s duration. The duration of a security will be expected to change over time with changes in market factors and time to maturity.

Cohen & Steers Capital Management, Inc. (Cohen & Steers) is a registered investment advisory firm that provides investment management services to corporate retirement, public and union retirement plans, endowments, foundations and mutual funds.


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